**2. Basel Committee on Banking Supervision**

Bank for International Settlement (BIS), the oldest international financial organization, was founded in 1930. Its members are central banks or the regulatory authorities of 60 countries. The committee aims to serve as a regulatory authority for monetary and financial stability and foster international cooperation.

West Germany's Herstatt Bank closed its operation on June 26, 1974, due to excessive foreign exchange risk that posed counterparty risk in international settlement with the banks in New York. Subsequently, at the end of 1974 due to this cross-jurisdiction implication, BIS formed "Committee on Banking Regulations and Supervisory Practices" also known as Basel Committee on Banking Supervision (BCBS) headquartered in Basel. Since the inception, the committee has established a series of banking standards to promote monetary and financial stability. Though at the beginning, the group's members were the governor of Central banks of G10 countries, at present, it has 45 institutions from 28 jurisdictions.

BCBS provides assistance to the central banks through regular cooperation to improve the quality of supervision in the banking industry. The committee sets regulations for the central banks. In addition, it acts consistently to enhance the financial stability and level playing field to avoid competitiveness conflicts globally. The member countries implement its prudential regulations and report to the committee periodically. BCBS decisions are expected to be followed by the member countries toward sound practice and standard guidelines in the financial industry [1].

The Committee's members are Argentina, Australia, Belgium, Brazil, Canada, China, European Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. BCBS performs as a forum for regular cooperation on banking standard, regulation, and supervision issues between the member countries. It provides comprehensive guidelines for managing bank capital to safeguard against operational and financial risk in an international standard. Toward this standardization in banking operation and supervision, the committee has published a number of landmark guidelines on capital adequacy known as Basel I, Basel II, and Basel III.

This guideline advises holding a minimum amount of capital on the riskweighted assets of the bank. This regulation is called the capital adequacy regulation (CAR) or minimum capital requirement (MCR).

#### **2.1 Regulatory capital and economic capital**

Banks as public confidence institution are strictly guided by regulations and supervision by the regulatory authority. Since risk is an integral part of any financial institution, in the process of providing different services to the economy banks come across different types of risk in their operation. As a result, risk is the subject of all regulation bases [2]. Regulators and risk managers define risk as an uncertainty that has adverse effect on the positive outcome of the bank like banks return, asset, or goodwill. Hence, the regulations intend to enhance the resilience of the bank in the stressed situations to protect the interest of the depositors and other associated counterparts of the bank.

In discussion of bank capital, the most widely used terms that come together are regulatory capital and economic capital. Regulatory capital as its name implies is the minimum level of capital required by the regulatory authority. Principally, the regulatory capital should be derived from the maximization of the social welfare function that takes into account the cost and benefit of the capital regulation [3]. Economic capital is the level of capital chosen by the shareholder of the bank. It relates with a desired rating required to safeguard the bank's losses at a certain confidence level. So, if the bank's loss during a period is higher than the initial level of capital, it will be in default. Therefore, the shareholder trades off between the costs of raise or increase of the equity against the benefit of reducing the banks probability of default. Mainly, cost of capital determines the relative position of the economic and regulatory capital. When the cost of capital is low, the economic capital is higher than the level of regulatory capital [3].

While discussing the economic capital and regulatory capital levels, the actual level of capital or actual capital arises. Actual capital is higher than the regulatory

**5**

*Capital Adequacy Regulation*

the minimum requirement.

**2.2 Basel I**

requirement (MCR) of the bank.

must be Tier 1 or core capital.

II—was developed.

above the minimum level.

**2.3 Basel II**

follows:

the market risk and associated capital against this risk.

*DOI: http://dx.doi.org/10.5772/intechopen.92178*

level chosen by the shareholder taking into consideration different regulatory requirements. Threat of closing the undercapitalized bank or avoidance of penalty insists the bank management and shareholders to keep the actual capital level above

In this chapter, we will discuss the regulatory capital or the minimum capital

In 1998, when the world economy faced the economic recession, the Latin American countries could not sustain their debts due to higher interest rates of loans and shorten repayment period [1]. These sovereign defaults possess critical situation for the international banks by eroding the capital buffer and global financial stability. The concern for global financial stability encouraged the BCBS committee to set up an international standard for risk measurement. The committee released a capital measurement system referred to as the "Basel Capital Accord" in July 1988 [4]. The principal of this measurement was to weigh the on-balance sheet and off-balance sheet asset according to the risk they possess. The accord required banks to hold at least 8% of risk-weighted assets (RWA) as capital; 50% of which

Initially Basel Accord I focused to the credit risk of the bank measured by the Cookie ratio. However, being criticized for exaggerating on the credit risk in 1996, an amendment was issued through incorporating the market risk to address banks' exposure in foreign exchange risk, securities trade, equities, commodities, and options [4]. This amendment permitted the bank to use internal model to measure

The first Basel Accord, i.e., Basel I was introduced among the member countries of G-10 which includes Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States. The accord was designed to implement among all of the internationally active banks across countries to make a level playing field, i.e., to avoid competitiveness conflicts globally. For large and complex institutions, the regulation becomes less significant. Finally, a more risk-sensitive and comprehensive capital structure guideline—Basel

As a response to Enron scandal and innovation of financial derivatives after the execution of Basel Accord I, a new regulatory framework was imperative to introduce. A more sensitive new capital requirement known as Basel II was initiated shortly

The Basel II accord released in 2004 was developed on three pillars, which are as

in 2004 to accommodate the highly complex on- and off-balance sheet items, promote more risk sensitive capital requirement through banks own assessment, and provide greater transparency. The purpose of the Basel II accord was to address the risk areas that were not covered by Basel I, to measure the capital requirement

i.Pillar I or minimum capital requirement (MCR)

ii.Pillar II or supervisory review process (SRP)

iii.Pillar III or market discipline (MD)

#### *Capital Adequacy Regulation DOI: http://dx.doi.org/10.5772/intechopen.92178*

level chosen by the shareholder taking into consideration different regulatory requirements. Threat of closing the undercapitalized bank or avoidance of penalty insists the bank management and shareholders to keep the actual capital level above the minimum requirement.

In this chapter, we will discuss the regulatory capital or the minimum capital requirement (MCR) of the bank.

### **2.2 Basel I**

*Banking and Finance*

cross-jurisdiction implication, BIS formed "Committee on Banking Regulations and Supervisory Practices" also known as Basel Committee on Banking Supervision (BCBS) headquartered in Basel. Since the inception, the committee has established a series of banking standards to promote monetary and financial stability. Though at the beginning, the group's members were the governor of Central banks of G10

BCBS provides assistance to the central banks through regular cooperation to improve the quality of supervision in the banking industry. The committee sets regulations for the central banks. In addition, it acts consistently to enhance the financial stability and level playing field to avoid competitiveness conflicts globally. The member countries implement its prudential regulations and report to the committee periodically. BCBS decisions are expected to be followed by the member countries toward sound practice and standard guidelines in the financial industry [1].

The Committee's members are Argentina, Australia, Belgium, Brazil, Canada, China,

European Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. BCBS performs as a forum for regular cooperation on banking standard, regulation, and supervision issues between the member countries. It provides comprehensive guidelines for managing bank capital to safeguard against operational and financial risk in an international standard. Toward this standardization in banking operation and supervision, the committee has published a number of landmark guidelines on capital adequacy

This guideline advises holding a minimum amount of capital on the riskweighted assets of the bank. This regulation is called the capital adequacy regula-

Banks as public confidence institution are strictly guided by regulations and supervision by the regulatory authority. Since risk is an integral part of any financial institution, in the process of providing different services to the economy banks come across different types of risk in their operation. As a result, risk is the subject of all regulation bases [2]. Regulators and risk managers define risk as an uncertainty that has adverse effect on the positive outcome of the bank like banks return, asset, or goodwill. Hence, the regulations intend to enhance the resilience of the bank in the stressed situations to protect the interest of the depositors and other

In discussion of bank capital, the most widely used terms that come together are regulatory capital and economic capital. Regulatory capital as its name implies is the minimum level of capital required by the regulatory authority. Principally, the regulatory capital should be derived from the maximization of the social welfare function that takes into account the cost and benefit of the capital regulation [3]. Economic capital is the level of capital chosen by the shareholder of the bank. It relates with a desired rating required to safeguard the bank's losses at a certain confidence level. So, if the bank's loss during a period is higher than the initial level of capital, it will be in default. Therefore, the shareholder trades off between the costs of raise or increase of the equity against the benefit of reducing the banks probability of default. Mainly, cost of capital determines the relative position of the economic and regulatory capital. When the cost of capital is low, the economic

While discussing the economic capital and regulatory capital levels, the actual level of capital or actual capital arises. Actual capital is higher than the regulatory

countries, at present, it has 45 institutions from 28 jurisdictions.

known as Basel I, Basel II, and Basel III.

associated counterparts of the bank.

tion (CAR) or minimum capital requirement (MCR).

capital is higher than the level of regulatory capital [3].

**2.1 Regulatory capital and economic capital**

**4**

In 1998, when the world economy faced the economic recession, the Latin American countries could not sustain their debts due to higher interest rates of loans and shorten repayment period [1]. These sovereign defaults possess critical situation for the international banks by eroding the capital buffer and global financial stability. The concern for global financial stability encouraged the BCBS committee to set up an international standard for risk measurement. The committee released a capital measurement system referred to as the "Basel Capital Accord" in July 1988 [4]. The principal of this measurement was to weigh the on-balance sheet and off-balance sheet asset according to the risk they possess. The accord required banks to hold at least 8% of risk-weighted assets (RWA) as capital; 50% of which must be Tier 1 or core capital.

Initially Basel Accord I focused to the credit risk of the bank measured by the Cookie ratio. However, being criticized for exaggerating on the credit risk in 1996, an amendment was issued through incorporating the market risk to address banks' exposure in foreign exchange risk, securities trade, equities, commodities, and options [4]. This amendment permitted the bank to use internal model to measure the market risk and associated capital against this risk.

The first Basel Accord, i.e., Basel I was introduced among the member countries of G-10 which includes Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States. The accord was designed to implement among all of the internationally active banks across countries to make a level playing field, i.e., to avoid competitiveness conflicts globally. For large and complex institutions, the regulation becomes less significant. Finally, a more risk-sensitive and comprehensive capital structure guideline—Basel II—was developed.

#### **2.3 Basel II**

As a response to Enron scandal and innovation of financial derivatives after the execution of Basel Accord I, a new regulatory framework was imperative to introduce.

A more sensitive new capital requirement known as Basel II was initiated shortly in 2004 to accommodate the highly complex on- and off-balance sheet items, promote more risk sensitive capital requirement through banks own assessment, and provide greater transparency. The purpose of the Basel II accord was to address the risk areas that were not covered by Basel I, to measure the capital requirement above the minimum level.

The Basel II accord released in 2004 was developed on three pillars, which are as follows:

i.Pillar I or minimum capital requirement (MCR)

ii.Pillar II or supervisory review process (SRP)

iii.Pillar III or market discipline (MD)
